Risk is back on; actually, it never left, and never will, which is good thing and today’s lesson, notes Landon Whaley.
Whenever anyone refers to the price action in financial markets as “risk-on” or “risk-off,” it makes me lose my freaking mind! It’s like being forced to watch the 1985 Memorial Day Massacre all over again, while simultaneously listening to the “Beaches” soundtrack on repeat.
There is no such thing as financial market risk being “on” or “off.” This isn’t the Karate Kid, you aren’t Ralph Macchio, and I’m sure as heck, not Mr. Miyagi. There is no risk-on or risk-off, Daniel-son.
Risk is always on, my friends, and the world was reminded of that fact last week. The problem is that many investors have no idea what the word risk really means.
S.A.T. Words
Raise your hand if you’ve ever been put to sleep by your financial advisor or money manager spewing terms like beta, standard deviation, kurtosis, and skewness. I feel your pain.
A lot of the confusion comes from the fact that the words “risk” and “volatility” are used interchangeably. Let me be clear; risk is not volatility; they are two different beasts.
Standard deviation and other measures of volatility may make you feel warm and cozy, but they can’t help you understand risk, because risk is not a number.
So, what exactly is risk?
Risk is an estimation of the likelihood of a permanent loss of capital if an unfavorable event occurs.
I’ve left you wanting, haven’t I?
You wanted me to tell you the index, calculation, or statistical measure that would help you discern just how much risk exists in the world, and more importantly, in your portfolio. I’m sorry, but I can’t. We can’t boil risk down to a number, but we can assess the probabilities of various outcomes and then position our portfolios in a way that tilts the scales in our favor.
This understanding of risk is why we came through last week unscathed while everyone and their mother was getting the woodshed treatment.
The Bottom Line
Human beings are hardwired to hate uncertainty. But if you think about it, there is no great reward if you don’t embrace uncertainty. The first time you asked your significant other out on a date, were you certain he or she would say yes? Of course not. There was uncertainty and a possible loss of ego if an unfavorable event occurred, and that person said no.
If you’re thinking of leaving a 20-year steady, paying gig to join a start-up because you want to control your own destiny and earn “buy-your-own-island” money, is there certainty? Nope. My friends, all of life’s greatest rewards live in the land of uncertainty, and successful investing is no different.
This week’s uncertainty is the Coronavirus (or, more precisely, the extent of its reach and impact, the virus itself is a certainty as is a certain level of contagion); next week (month or year), it will likely be something else.
To earn high, risk-adjusted returns, you must embrace uncertainty and have a process for understanding the ever-changing and unintended sources of risk that lurk in financial markets.
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